Frequently Asked Questions: How It Works

Q: Your setup for the S&P 500 just went bullish on Monday’s open, and the index is already down 2 percent as of Tuesday. Are you throwing in the towel?

A: No, it doesn’t work that way. First, this is a mechanical system, and that means following the signals with discipline, even when it’s down. Also, if you take a look at my backtesting results for this setup and my other ones, you’ll see they haven’t had a 100-percent success rate. No trader or system does. Even the best traders typically have only a 60-percent win record.

Because of that, I am prepared to lose money on many of my trades. I set a stop level and position size that’s appropriate to my risk level based on past volatility and losses in a setup. (See more on risk-control, stops and position sizing on my How It Works page.)

Also, my signals last an average of three or four weeks, and lots can happen between now and then. And it takes more than a single loss or two to make me question my system, which is based on results from dozens of trades and years of data.

A: Your signal has made money, but the market has turned down. Why are you waiting for your setup to give a new signal before you get out?

Q: Firstly, a trading strategy is useless if you don’t follow its signals with 1,000,000% (is there such a thing?) discipline. All your work developing it goes right into the toilet. A trader needs to have confidence his or her system will work or go back to the drawing board and improve it so they do. Or give up, and do something else. Whenever I start second-guessing ourselves, that’s when the big mistakes and losses start piling up.

I don’t care at all what the price is doing right now. I don’t really even care that much if this or another trade wins or loses money. All systems lose money some of the time. The key is winning over the long-term and cutting losses with stops and position sizing.

In any event, who knows what will happen between now and when the sell signal comes. Maybe the market will go back my way!

Q: What would make you question a losing signal?

A: If a trade loses more than my stop level, I automatically sell my position. If the trade loses more than the setup has ever lost since the data started (usually in 1995 for most Commitments of Traders markets), I will cease trading the setup for four weeks. I call that my Black Swan Rule. Read more about all this at my How It Works page. (In trading, a “Black Swan” is a hard-to-predict, catastrophic event. The idea comes from Nassim Nicholas Taleb and his acclaimed book, The Black Swan: The Impact of the Highly Improbable.)

As well, if my overall portfolio is down more than six percent in any four-week period, I’ll stop trading the entire system for four weeks.

Q: What is your rationale for the trade delays in your setups?

A: The trade delays are based on my backtesting. I test various trade delays for each setup – from zero to eight weeks. I use the ones that give the best results. Why does it work best to delay a trade in some cases? I can’t say for certain, but I believe it’s because it can take time for major positioning changes to work themselves through into the broader markets. It could also have to do with the differing dynamics of mean-reversion in various markets after extreme positioning occurs in a key trader group.

Q: I’ve read that the Commitments of Traders data is obsolete. It no longer works, probably because too many people know about it. Today, for example, the market is caving in, while the commercial traders – the so-called “smart money” – just got extremely bullish on the S&P 500.

A: Contrary to conventional wisdom, the S&P 500 does not usually go up when the commercial traders get more bullish. In fact, the opposite takes place. The commercial hedger net position has a negative, -25-percent correlation with S&P 500 weekly open prices a week after the COT report comes out (between 1995 and Feb. 2010).

That’s right: a negative correlation. So trading alongside the commercials week to week would have lost you piles of money. That actually makes sense, in a way. These guys accumulate positions as markets decline and vice versa. It’s only when they hit extremes of positioning that I think it’s safe to trade alongside them. Various analysts like Larry Williams discovered this long before I did. In my research, I’ve found the most robust signals usually come when the commercial traders agree with at least one other group of traders, like the small traders, who would usually be faded. That’s why I use two signals in my own S&P 500 setup and only trade when both agree. On top of that, this particular signal tends to work most reliably not right away – but with a delay of about three weeks on average.

So has the COT data slowly become obsolete? I’ve seen this said from time to time. Again, the reality is quite the opposite. Here are correlations in various time periods between the commercial net position and S&P 500 prices a week later:

– March 1995-Nov. 1997: -71%

– Dec. 1997-Dec. 1999: +14%

– Dec. 1999-March 2003: 0%

– March 2003-June 2008: +34%

– March 2003-Feb. 2010: +53%

– June 2008-Feb. 2010: +63%

– March 1995-Feb. 2010: -25%

(These correlations are not the same in other markets.) So clearly, the COT data has changed dramatically over the various periods in how it interacts with market prices. If anything, the commercial hedgers are now trading much more in lockstep with the S&P 500. But the relationship seems to evolve quite often, so using it alone to trade is probably very much a random exercise. This is why I think the data needs to be filtered with some more complex trading system.

Q: Can your signals be traded with an individual company’s stock? For example, could you buy a specific mining stock to trade your gold signal?

A: Not really. Company shares can be influenced by numerous factors that have nothing to do with the market in question. The further the traded security is from the underlying market, the less it will track it well.

Q: Couldn’t you improve your results with technical indicators based on the price action?

A: My backtesting so far hasn’t shown any price-based indicators that improve the results and robustness of my setups. Mind you, I haven’t tested technical indicators comprehensively. However, as David Aronson points out in his excellent book Evidence-Based Technical Analysis, most commonly used technical indicators don’t make money.

Q: Do you ever put on discretionary trades not based on a COT signal?

A: Yes, but not ones that are directly opposite to a COT signal. For example, if my COT signal is short the S&P 500, I wouldn’t go long the S&P 500. But I may go long a different equity index or some other sector or stock. I generally place discretionary trades based on breakouts of Tom DeMark Setup Trend lines on the daily and weekly charts. See this story I did on DeMark’s interesting indicators to learn more.

Q: Why don’t you have a setup for the e-mini S&P 500 contract or the NASDAQ 100 mini contract?

A: So much to do, so little time. It’s on my to-do list to test lots of other markets, but I just haven’t gotten to it yet. That said, past research of mine suggests trading setups based on the mini contracts haven’t been as robust or given as good results as those for the larger contracts.

Q: Are the commercial hedgers always the “smart money”? Are the large speculators and small traders always the “dumb money”?

A: No to both questions. In most cases, the commercial traders are positioned correctly – i.e. highly long – when a market is about to go up. Conversely for the large specs and small traders, they usually tend to be positioned wrong – i.e. highly short – when a market is about to go up. But this popular understanding of the COT data isn’t always confirmed in backtesting. My testing of the data has shown that those patterns aren’t true of every market. Some of the best signals trade on the same side as the small traders or large specs and fade the commercials. As well, much depends on the timeframe (i.e. the setup parameter values) you use to look at the data. Under some conditions, it might be best to fade the small traders in a market, while in others it’s best to trade alongside them.

Think back again to how the small traders are positioned at a market bottom, for example. As trend followers, they were actually correctly positioned if they were highly short. If they trade with success, a set of parameter values that captures their trend-following positioning would work well.

Q: You have a setup based on the commercial and small trader net positioning, but the large speculators are saying something different this week. For example, they are signaling it’s best to be long, while your setup says to be short. Will you be ignoring your signal?

A: No. My setups are based on backtesting all groups of traders – both for their net positioning and total open interest. The two or three signals I’ve decided to use were the best ones I found. It’s irrelevant what other trader groups are doing, until it’s time to update my backtesting.

Q: Isn’t open interest moving from the large S&P 500 contract to the e-mini contract? Doesn’t that mean your setup based on the larger contract is obsolete?

A: It’s true there’s been steady long-term growth in the commercial total open interest in the mini S&P 500 contract. That actually started pretty much at the beginning of the data in 1997. That, however, hasn’t been reflected in a long-term decline in the commercial total open interest in the larger S&P 500 contract. Neither has it been reflected in any kind of deterioration of trading setup backtesting results in more recent years. The setup I’m using for the S&P 500 has results in the 2003-2008 period that match those in the 1995-2003 timeframe.

It’s also true that the commercial total open interest in the larger S&P 500 contract has fallen a lot since late 2008 (as of this writing, in Aug. 2009). But so has the mini commercial total open interest. As of Aug. 2009, it was still well off where it was last year.

It’s also important when backtesting trading systems to look at more than just one year’s worth of data. Doing that, you’ll notice that the commercial total open interest in the larger SPX contract doubled between June 2008 and its peak last Dec. 2008. So even though it’s true it’s fallen since then, it fell from bubble highs.

A more fundamental question is this: Is the commercial total open interest even a reliable indicator for trading? My research suggests that data is probably not as useful from a trading viewpoint as the signals I did choose to use for my S&P 500 setup – the commercial and small trader net positioning as a percentage of the total open interest. I didn’t get a single potential trading setup out of the total commercial open interest during my backtesting of the S&P 500 COT data.

Q: Your setup based on the commercial traders in the S&P 500 was long while the commercials in the e-mini S&P 500 contract were highly short. Doesn’t that mean your setup was wrong?

A: The commercial traders in the e-mini contract are not necessarily the same folks as those in the larger SPX contract, which is five times bigger. The CFTC’s reporting levels for both contracts are the same. That means the commercial category in the mini contract includes a number of traders who would be considered small traders (i.e. the non-reportable category) in the larger contract.

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Hi, I really like your site and the trades based on COT data. I would though like clarity on this point – i think you are using the big S&P futures COT data instead of the emini. Dont you think it would be time to change the contract to emini. I was just checking up, the emini does 400 times the volume of the larger contract daily, while the OI in emini is 10 times more.